On Could 15, 2019, the U.S. Court docket of Appeals for the Sixth Circuit affirmed the Tax Court docket’s ruling household was answerable for the unpaid taxes associated to the sale of their enterprise. The appellate opinion in Billy F. Hawk, Jr., GST Non-Exempt Marital Belief et. al v. Commissioner concerned a family-owned bowling enterprise, “Vacation Bowl,” which the surviving partner elected to promote following the demise of her husband. The Hawk household labored with a dealer, who helped them enter right into a transaction that proved too good to be true. The concept was that the corporate would promote most of its belongings to a 3rd social gathering, producing a taxable achieve. Then, the household would promote their shares within the firm to a special third social gathering, who may buy these shares at a premium as a result of it may offset the asset-sale achieve with its personal losses (decreasing the quantity of tax due).
The corporate did proceed to promote most of its belongings, the bowling alleys, to a different firm in trade for $four.2 million money. This triggered about $1 million in federal revenue tax legal responsibility, plus about $200,000 in state tax legal responsibility. Along with the bowling alleys, the corporate additionally owned a horse farm valued at $777,000. The members of the family bought the horse farm from the corporate in trade for a few of their shares, leaving the corporate with $four.2 million of money and no different belongings. The household then proceeded to show round and promote its shares to a different firm, MidCoast, for $Three.four million. They believed this would depart them “forward” by a number of hundred thousand dollars as a result of they might now not be answerable for the tax. MidCoast took out a mortgage from one other firm, Sequoia Capital, to assist fund the acquisition.
The issue, in fact, is that MidCoast by no means paid the taxes (not only for this firm, however for a lot of others as nicely). This triggered the Inner Income Service to come back after the Hawks beneath Inner Income Code Part 2601, which permits the federal government to pursue a delinquent taxpayer’s transferees for unpaid taxes. One of these motion is introduced in federal courtroom, however the authorities is allowed to behave as a personal creditor bringing an motion beneath the legal guidelines of that state. In Hawk, the IRS argued that that mortgage between Sequoia and MidCoast was a sham and that the household truly acquired its personal money as a part of the sale of its shares. On the whole, IRC Part 2601 asks three questions: (1) did the corporate owe any taxes; (2) are the defendants transferees of the corporate; and (Three) in the event that they’re transferees, would they be liable to a creditor beneath the state’s fraudulent switch legal guidelines?
Financial Realities Doctrine
There’s no dispute that the corporate owed taxes because of the asset sale, and the members of the family have been clearly transferees of the corporate with respect to the horse farm since IRC Part 6901(h) defines “transferee” as together with “a donee, inheritor, legatee, devisee, and distributee.” However, with respect to the remaining money they’d acquired, the Hawks tried to assert they have been truly distributes of MidCoast and never of their very own firm. The federal government’s response was to invoke the so-called “financial realities” doctrine.
The courtroom mentioned a number of elements resulting in the conclusion that this transaction lacked financial substance. First, the corporate truly acquired its personal money within the sale—its funds have been wired into an escrow account after which instantly again to the household. The Sequoia mortgage wasn’t structured the identical was as a standard mortgage—it was “secured” by the corporate’s money (a fungible asset), and no curiosity would have been due except MidCoast defaulted. Additionally, whereas the events had ready mortgage paperwork, they’d signed only a few of them. In actuality, the courtroom concluded, the transaction wasn’t a real sale—it was simply an trade of money.
As soon as the Hawks have been decided to be transferees, the federal government may pursue them as collectors beneath state regulation. On this case, Tennessee’s Uniform Fraudulent Switch Act deems a switch as fraudulent if “the debtor made the switch…with out receiving a fairly equal worth in trade for the switch…and the debtor…turned bancrupt because of the switch.” Tenn. Code Ann. Part 66-Three-306(a). There have been additionally three inquiries to be answered with respect to the state regulation declare: (1) did the transaction depend as a switch; (2) did the corporate obtain moderately equal worth in trade; and (Three) did the corporate turn into bancrupt?
Transaction Handled as Sham
The courtroom decided that the transaction did depend as a switch, which is outlined very broadly beneath Tennessee state regulation and even consists of the “oblique” disposition of an asset in trade for some consideration. If nothing extra, the corporate’s receipt of their very own funds would have constituted an oblique disposition. As well as, the household’s trade of shares of inventory for the horse farm wouldn’t have been an trade for moderately equal worth. It triggered a lower within the firm’s steadiness sheet, and the corporate didn’t obtain something when MidCoast purchased the shares from the Hawks. The corporate additionally turned bancrupt following this transaction. After distributing the money to its shareholders, it didn’t have sufficient left to pay its taxes.
The Hawk household argued that they acted in good religion and didn’t find out about MidCoast’s scheme. Sadly for them, Tennessee’s legal guidelines don’t make exceptions for lack of expertise. On this case, the financial actuality of the transaction was that it lacked substance and ought to be handled as a sham—even when the transferees have been unknowing contributors. Apparently, the courtroom concluded with an apart that this transaction may need labored (not less than in principle) if the info had been completely different. If the corporate buying Vacation Bowl may have offset its good points by producing losses following the sale, and if the transaction had been correctly documented and carried out, this story may need ended in another way.